Ghost of 1994 Haunts the Bond Market

A familiar speculative tone persists, although few see a fixed-income rout of that magnitude.

Parallels to 1994 terrify bond players who remember the rout that accompanied the Federal Reserve's tightening campaign of that year. And while enough differences exist between then and now to suggest the pain of interest rate hikes won't be as severe, investors would be unwise to write off the similarities completely.

Over the past five weeks, bonds have sold off amid growing expectations for a rate hike this summer. Although the market appears to have stabilized in recent days, analysts and investors remain concerned that history will repeat itself.

"Will 2004 replay the bond market bloodbath of 1994?" asked Richard Berner, chief economist at Morgan Stanley. "At this juncture, bond market carnage seems unlikely. But there are also similarities, many of which support our bearish stance on bonds."

Back in 1994, the Fed embarked on a series of interest rate hikes after keeping monetary policy on hold for an extended period. The result was a veritable crash in bonds. The yield on the 10-year Treasury rose to more than 8% in November 1994 from just 5.7% before the first hike came in February of that year.

Conventional wisdom holds that the Fed didn't communicate its intentions well enough to the financial markets and that the six rate hikes -- which pushed the fed funds rate up to 5.5% from just 3% -- came as a shock.

"Only a few people had an inkling of what was happening," said Jim Bianco, president of Bianco Research. "Now, a lot more people have an understanding of what's happening."

Indeed, fed funds futures are pricing in at least 50 basis points of tightening by the Sept. 21 meeting.

Pundits also note that the outlook for inflation is different this time around and that the Fed can afford to be more patient in raising rates than it was back then.